oligopoly

Oligopoly (Cambridge AS & A‑Level Economics 9708)

1. Definition and Core Characteristics

• Definition (7.6.1): A market structure in which a small number of large firms dominate an industry and each firm’s decisions on price, output and advertising are mutually inter‑dependent.
• Key characteristics (7.6.2‑7.6.5):
  • Few dominant firms (normally 2‑10).
  • High barriers to entry (see 1.1).
  • Products may be homogeneous (e.g., steel) or differentiated (e.g., cars, smartphones).
  • Strategic price‑setting behaviour: each firm must anticipate the likely reaction of rivals when it changes price, output or advertising.
  • Potential for collusion (explicit or tacit) and for various forms of non‑price competition.

1.1 Barriers to Entry (required by the syllabus)

• Economies of scale – lower average costs at large output.
• High sunk costs (e.g., costly plant, network infrastructure).
• Patents, licences and other legal protections.
• Brand loyalty and heavy advertising.
• Control of essential resources or distribution channels.

1.2 Measuring Market Concentration (7.6.6)

Two quantitative tools are used in the syllabus to assess the degree of oligopoly.

Measure	Formula	Cambridge interpretation thresholds
Concentration Ratio (CR4 or CR5)	Sum of market shares of the 4 (or 5) largest firms	CR ≥ 60 % → high concentration (oligopoly); 40‑60 % → moderate; < 40 % → low.
Herfindahl‑Hirschman Index (HHI)	Σ (market share2) for all firms (share expressed as a percentage)	HHI ≥ 2500 → highly concentrated; 1500‑2500 → moderately concentrated; < 1500 → competitive.

Example: Market shares 30 %, 25 %, 20 % and 15 % for the four biggest firms.

• CR₄ = 30 % + 25 % + 20 % + 15 % = 90 % → highly concentrated.
• HHI = 30² + 25² + 20² + 15² = 900 + 625 + 400 + 225 = 2150 → moderately‑high concentration.

2. Behavioural Models of Oligopoly (7.6.7)

2.1 Kinked‑Demand Curve – Explanation of Price Rigidity

• Assumes firms expect rivals to match price cuts but not price rises.
• Demand is elastic above the current price and inelastic below it, producing a “kink” at the prevailing price.
• The associated marginal‑revenue (MR) curve has a discontinuity; marginal cost can move within a range without changing price.
• Used in the syllabus to explain why oligopolistic markets often exhibit **price stability** despite cost changes.

2.2 Cournot Model – Quantity Competition (simultaneous move)

Firms choose output simultaneously, treating rivals’ quantities as given.

• Output is lower than in perfect competition but higher than a monopoly.
• Price is above marginal cost but below the monopoly price.

2.3 Bertrand Model – Price Competition (simultaneous move)

• Firms set prices simultaneously, assuming rivals’ prices are fixed.
• Homogeneous‑product case (Bertrand paradox): with constant marginal cost \(c\), the Nash‑equilibrium price is \(P = c\). Any higher price would be undercut.
• Product‑differentiated case: each firm faces a downward‑sloping demand curve; equilibrium price exceeds marginal cost.

2.4 Stackelberg Model – Leader‑Follower Quantity Competition

One firm (the leader) chooses output first; the follower observes this and then chooses its own output.

• Leader enjoys a first‑mover advantage and earns higher profit than the follower.
• Total industry output is greater than in Cournot, so market price is lower.

2.5 Price‑Leadership (Dominant‑Firm Model) – 7.6.7

• One large “dominant” firm sets the market price, usually at a level close to its marginal cost.
• Smaller “price‑follower” firms accept this price and compete on output (their marginal cost is higher than the dominant firm’s).
• Diagrammatically, the dominant firm’s marginal cost curve determines price; the followers’ marginal cost curves determine the quantity they supply at that price.
• Common in markets where a clear market leader exists (e.g., hub‑carrier airlines, major telecom operators).

3. Collusion, Cartels and Tacit Coordination (7.6.8)

3.1 Explicit Collusion – Cartels

• Formal agreement to fix prices, limit output, or allocate markets.
• Behaviour mimics a monopoly – joint profit maximisation.
• Example: OPEC’s oil‑production quotas.
• Legal status: illegal under most competition‑law regimes; penalties include heavy fines, imprisonment and civil damages.

3.2 Tacit Collusion

• No written agreement; firms coordinate implicitly through signalling, price‑leadership or mutual forbearance.
• Typical forms:
  • Price leadership (see 2.5).
  • Mutual forbearance – firms avoid aggressive price cuts.
  • Parallel non‑price competition – matching advertising spend or R&D intensity.
• Harder to prove legally, but competition authorities still monitor for “concerted practices”.

4. Types of Competition in Oligopoly

4.1 Price Competition

• Illustrated by the Bertrand model and price‑leadership.
• Can lead to price wars (Prisoner’s Dilemma outcome) when firms defect from a collusive arrangement.

4.2 Non‑Price Competition

• Advertising and branding (e.g., car manufacturers).
• Product differentiation – quality, design, after‑sales service.
• Research & Development – creating perceived superiority.
• Loyalty programmes, warranties, financing offers.

5. Game Theory and Strategic Interaction (AO2‑AO3)

• Normal‑form (matrix) games illustrate strategic choices.
• Key concepts:
  • Dominant strategy – a strategy that yields a higher payoff regardless of the rival’s action.
  • Nash equilibrium – a set of strategies where no player can improve profit by unilaterally deviating.
  • Prisoner’s Dilemma – shows why rational firms may end up in a price war even though cooperation would give higher joint profit.

Firm A \ Firm B	Co‑operate	Defect
Co‑operate	(\(\pi_{CC},\pi_{CC}\))	(\(\pi_{CD},\pi_{DC}\))
Defect	(\(\pi_{DC},\pi_{CD}\))	(\(\pi_{DD},\pi_{DD}\))

Typical ranking: \(\pi_{DD} > \pi_{CD} > \pi_{CC} > \pi_{DC}\). The unique Nash equilibrium is (Defect, Defect) – a price war.

6. Advantages and Disadvantages of Oligopoly

Advantages	Disadvantages
Economies of scale → lower average costs. Resources for R&D, innovation and large‑scale advertising. Stable employment and long‑term investment. Potential for “efficient” outcomes when firms cooperate (e.g., price‑leadership avoids wasteful price wars).	Higher prices and reduced output compared with perfect competition. Risk of collusive behaviour that harms consumer welfare. Strategic uncertainty can lead to wasteful advertising or destructive price wars. Barriers to entry limit competition and can entrench market power.

7. Real‑World Examples (7.6.9)

• Automobile industry – few global manufacturers (Toyota, Volkswagen, GM); heavy branding, R&D – illustrates product differentiation and non‑price competition.
• Airline markets on major routes – dominant hub carriers set fares; smaller airlines follow – classic price‑leadership.
• Telecommunications – limited number of network owners, high sunk costs and spectrum licences – high barriers, often a dominant‑firm situation.
• Oil market – OPEC – explicit cartel that coordinates output – example of explicit collusion.
• Soft‑drink market (Coca‑Cola vs. PepsiCo) – intense advertising, product line extensions – non‑price competition.
• Cement industry (e.g., Lafarge‑Holcim vs. HeidelbergCement) – duopoly with relatively homogeneous product – often used to illustrate the Cournot model.
• Airline ticket pricing (low‑cost carriers vs. legacy airlines) – frequent under‑cutting shows Bertrand‑type price competition.
• Smart‑phone operating systems (Google Android vs. Apple iOS) – leader‑follower dynamics resembling Stackelberg, where Android’s early market share influences Apple’s strategic choices.

8. Diagrammatic Illustrations (AO1)

• Kinked‑demand curve with the associated marginal‑revenue discontinuity.
• Cournot reaction‑function diagram for a duopoly.
• Bertrand price‑under‑cutting diagram (price = marginal cost).
• Stackelberg leader‑follower output diagram.
• Price‑leadership diagram showing dominant‑firm marginal cost, market price and follower output.
• Concentration‑ratio and HHI calculation example.

Diagram Checklist (what examiners look for)

• Axes clearly labelled (Price on vertical, Quantity on horizontal).
• All relevant curves (Demand, MR, MC, Reaction functions, etc.) drawn and labelled.
• Key points marked (kink, equilibrium output, price, profit‑maximising point).
• Shaded areas where appropriate (e.g., dead‑weight loss, profit).

9. Welfare Analysis and Competition Policy (A‑Level extension)

• Compared with perfect competition, oligopoly typically results in:
  • Lower consumer surplus (higher price).
  • Higher producer surplus (profits above normal).
  • Dead‑weight loss due to reduced output.
• If firms collude (explicitly or tacitly) the welfare loss is larger – the market behaves like a monopoly.
• Competition authorities (e.g., the Competition and Markets Authority, EU Commission) use tools such as:
  • Market‑share thresholds (CR ≥ 60 %, HHI ≥ 2500) to identify oligopolies.
  • Investigations into price‑fixing, market‑sharing or abuse of dominant position.
• Policy responses include:
  • Merger control – preventing further concentration.
  • Regulation of dominant firms (price caps, access‑to‑infrastructure rules).
  • Encouraging entry (e.g., reducing sunk‑cost barriers).

10. Key Points to Remember for Exams (AO1‑AO3)

1. Identify an oligopolistic market by the number of firms, barriers to entry, and concentration measures (CR₄, HHI).
2. Explain price rigidity using the kinked‑demand model; contrast with the outcomes of Cournot (quantity) and Bertrand (price) competition.
3. Distinguish the four main behavioural models (Kinked‑Demand, Cournot, Bertrand, Stackelberg) and state when each is most appropriate:
   • Kinked‑Demand – price rigidity, homogeneous or differentiated products.
   • Cournot – firms choose output, simultaneous move, product relatively homogeneous.
   • Bertrand – firms choose price, simultaneous move, homogeneous product (paradox) or differentiated product.
   • Stackelberg – clear leader‑follower timing, usually in markets with capacity‑setting advantage.
4. Define and differentiate:
   • Explicit collusion (cartels) vs. tacit collusion (price leadership, mutual forbearance).
   • Price competition vs. non‑price competition (advertising, product differentiation, R&D).
5. Apply game‑theoretic terminology: dominant strategy, Nash equilibrium, Prisoner’s Dilemma. Be able to draw a simple 2×2 matrix and state the likely outcome.
6. Use real‑world examples to illustrate each model and each type of collusion or competition.
7. When answering essay questions, evaluate welfare effects (consumer surplus, producer surplus, dead‑weight loss) and discuss the role of competition policy and legal restrictions.